Do I Claim Profit Sharing Payouts as Income on Federal Taxes?

If your employer offers a profit-sharing plan, then you're getting contributions to a savings account based on the company's profits, or some other measure, at the discretion of management. There may be some terms and conditions on when you can withdraw the money, and how long you have to stay in the job to collect the full amount. The IRS is clear on profit-sharing contributions. Unless the profits go into a tax-deferred retirement account, they're taxable compensation.

TL;DR (Too Long; Didn't Read)

You will need to claim profit sharing payouts on your tax return in most situations. However, you will not be required to do so if these payouts are routed into a tax-deferred retirement account.

Profit-Sharing Basics

Profit-sharing plans and 401(k)s are both savings accounts that employers set up for their employees. But their basic structures are different. Profit-sharing takes contributions only from the employer, while in a 401(k) the employee makes contributions and the employer may match them, based on a percentage of the employee's contribution or salary. As for taxes, the IRS looks at how the account is set up to decide whether the contributions are taxable.

Paying In and Reporting

A "cash plan" is one in which the employee receives direct payment, in the form of cash, check or company stock. These benefits are subject to income tax as ordinary compensation, in the year they're paid. The employer will withhold income taxes at your withholding rate and report these numbers to the IRS either on Form W-2, for regular employees, or a 1099 for independent contractors.

Either way, you must report the income to the IRS. If the employer used a W-2, then he withheld payroll taxes and paid half on his own. With a 1099, you're obligated to pay the full payroll tax rate on the income for Social Security and Medicare.

Contribution Limits

The IRS also sets limits on "qualified" plans, which can be deferred, or combination plans. Employer contributions to these plans max out. As of the 2018 tax year, the IRS set the maximum contribution at 25 percent of all employee compensation or $55,000, whichever is less. In a "deferred plan," the profit-sharing benefit goes into a retirement account, which the employee can only access under certain conditions, such as reaching the age of 59-1/2.

As an employee, you don't report the contribution as taxable income and the money grows tax-free until you take a distribution. With a "combination plan," the employee can defer part of the profit-sharing and accept another part immediately as compensation. The deferred portion grows tax-free until the employee withdraws it. The direct compensation incurs income tax in the year it's paid.

Retirement Distributions

If you're retired and taking distributions from a qualified profit-sharing plan, then the tax treatment is the same as for other qualified plans, such as 401(k)s and IRAs. Taking a distribution before the age of 59-1/2 incurs a 10 percent tax penalty. You must begin distributions by the year you turn 70-1/2, at which time the IRS imposes a required minimum distribution.

the nest